Pros and Cons of Business Entities

June 10, 2018
By
Brown & Vogel, LLC

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Advantages and Disadvantages of Sole Proprietorships

A sole proprietorship is a business owned by a single individual. There
is no formal separation of the business assets and operations apart from
the individual. The greatest advantage of the sole proprietorship is its
ease of start-up. You, as proprietor, simply begin doing business. It
is less expensive to establish a sole proprietorship since no formal documentation
is required. You do not have to pay yourself a salary, but can simply
make withdrawals from your business account as needed. A sole proprietorship
also does not require any formalities such as formal meetings, or records
of officers’ or directors’ decisions. There is no need to
obtain an employer identification number (EIN) unless there are employees,
or unless you are obligated to remit sales tax for products sold. Also,
if the business is operated under an assumed or trade name, you may be
required to register that name with the state.

The disadvantages of operating as a sole proprietorship include the inability
to take advantage of certain tax deductions that are available to other
business entities, as well as unlimited liability for the owner. A sole
proprietor is personally liable for any damages that are incurred in the
course of running that business, and all of the owner’s assets are
at risk – whether inside the business or out. This is a huge drawback,
even if the business appears to be free of any liability risk. Even a
business as mundane as house cleaning or dog walking can generate huge
liability problems for the owner if the business is operated as a sole
proprietorship. In summary, sole proprietorships offer no asset protection,
few planning options, and few good exit strategies.

Advantages and Disadvantages of Partnerships

A partnership is an association of two or more persons to carry on as co-owners
of a business for profit.

A general partnership is formed when two or more parties enter into an
agreement to conduct a business for profit or mutual benefit. That agreement
may be written or oral, formal or informal. Since all general partners
will have a direct involvement in the operations of the business, each
of the general partners will also be held liable for the debts and obligations
of the partnership. In fact, the partners are liable for the acts of their
fellow partners who conduct business. This shared liability is a serious
disadvantage to forming this type of business entity. It is the primary
reason that, for many advisors, the general partnership has limited appeal
as a business structure.

A limited partnership is a creature of state law, and generally requires
at least one limited partner and one general partner. The general partner
has unlimited liability for partnership debts, similar to the sole proprietor
or partner in a general partnership. The limited partner has limited liability,
limited to their investment in the partnership. This type of business
arrangement makes sense if there are active partners who carry out the
business, and passive partners who invest in the business but do not have
any day to day responsibilities. Usually, in order to provide liability
protection for the general partner, the general partner of a limited partnership
will actually be an entity that has limited liability, such as a corporation
or limited liability company.

Both forms of partnership are pass-through entities for purposes of taxation.
The partnership does not pay federal income tax at the partnership level.
Instead, the partners report the income or loss on their individual tax
returns. Interests in most partnerships, and especially limited partnerships,
are not easily transferred. Many limited partnerships limit the transferability
of limited partnership interests in the written partnership agreement.

Advantages and Disadvantages of Corporations

Corporations are formed and governed under state law. Generally, state
law requires corporate formalities to be followed in order for the corporation
to be treated as a separate entity from the owners. A C corporation is
a corporation whose income is taxable, by both federal and state governments,
at the corporate tax rate. As a result, a C corporation is subject to
“double taxation” because the corporation pays its own tax
on its income and, when the earnings of a corporation are distributed
to shareholders, it is taxed a second time as a dividend.

An S corporation is not taxed as a separate taxable entity. The corporation’s
income or loss passes through to the corporation’s shareholders
without being taxed to the corporation. This is similar to taxation for
partnerships. The shareholders report their share of the income on their
personal income tax returns. S corporations have limits on who may become
a shareholder.

A “closely-held corporation” is a corporation owned by just
a few people as opposed to a public corporation whose stock can be purchased
by the public on one of the stock exchanges.

Corporations also benefit from an unlimited lifespan. The corporation is
not affected by the death or bankruptcy of a shareholder, unlike general
partnerships or sole proprietorships. Of all the benefits of doing business
as a corporation, the single most important benefit is limited liability
for the shareholders. Assuming that all corporate formalities are followed
(which is not too difficult to accomplish), shareholders will not be liable
for business debts.

Advantages and Disadvantages of Limited Liability Companies (LLCs)

Limited liability companies are a product of state law. Although a much
newer form of business entity than corporations, they are available in
all states. In many cases the LLC may be a better choice than a corporation.
In fact, a limited liability company combines the best attributes of a
corporation, such as limited liability for members, with pass-through
taxation, similar to a partnership. An LLC is owned by members, and can
be managed either by the members or by a manager who is elected by the
members. LLC members can be individuals or any other type of entity, including
trusts. Also, non-resident aliens can be members, unlike shareholders
of an S Corporation. This affords an LLC great flexibility in ownership
and structure.

A key benefit of an LLC is the ability to choose how that entity will be
taxed. An LLC can elect to be taxed as a C corporation, an S corporation,
or a partnership, and can even be disregarded for tax purposes in some
states – making it similar to a sole proprietorship for taxation purposes.

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